No Vacation: Tax Rules Tighten on Getaway Homes

But not far enough to be away from the IRS. Tax rules applying to rental income from a vacation home that you use for your own vacations just got more complicated.

The vacation home market is just opening for this year, and if trends hold, it will be a blockbuster. With home prices scraping along the bottom, many people are circling vacation destinations looking for bargains. The National Association of Realtors‘ 2012 Investment and Vacation Home Buyers Survey reported that vacation home sales rose 7% last year, and now account for 11 percent of all home sales. (By way of contrast, sales of primary homes dropped 15.5% in 2011.)

But IRS rules are no day at the beach.

Rules issued at the end of 2011 further complicate how you must allot ‘personal’ and ‘commercial’ days when you are trying to write off part of your vacation home because you have rented it out.

According to Janet Hagy, an Austin, TX, certified public accountant, the definition of ‘personal’ use now includes your family and any member of a holding company you might have created so you can share ownership of the property.

Thinking of a tax-free house swap so you can vacation on the cheap somewhere else? Think again: swaps are also considered ‘personal use’, even if you charge rent. And if you charge less than market rent to friends, you’ll be stuck making up the difference to the tax man.

This is on top of an already complicated use formula. Traditionally, a second home counts as a ‘personal property’ if you occupy it for 14 days annually or 10% of the days during the tax year. But if the property is rented for 15 or more days, then you must prorate any deductions or losses. Of course, all this gets even more tangled if you share ownership.

Before you dive in to a tempting purchase:

- Review the tax and cash flow implications with your accountant, especially if you are thinking that the house will ‘pay for itself’ through rental income.

- Analyze the carrying costs of the property, including property taxes, insurance, and long-distance caretaking during the off-season.

- Consult with your investment advisor to see if adding the property to your portfolio will overweight the recommended proportion of real estate in your asset mix.

- Review shared-ownership proposals with the worst case scenario in mind. If another of the owners cannot fulfill his obligation, the remaining owners will be forced to pick up the slack, and rental income may or may not provide after-tax relief.